transfer pricing

Consider the case of a Japanese company that makes cars in Brazil, which it then sells in the US. Its internal control books will allocate a portion of the revenues and costs of a given car to operations in Japan for use of the brand name and the firm’s intellectual property, another portion to the manufacturing operations in Brazil and a third to the sales operations in the US.

This allocation process is called transfer pricing. This in itself is a benign process. After all, the firm has to understand whether Brazil is a profitable place to make cars and whether the Brazilian output should be allocated to the US or to other, potentially more profitable, markets.

What makes transfer pricing controversial, however, is that the firm also has tax books. And the logic that dictates the management control profit decisions may not be the same as the one that minimizes taxes.

An example:

When I began working as a global portfolio manager in the mid-1980s, Tokyo was a very important stock market. Multinational brokers all had lavish offices in swanky downtown districts and very large staffs–all of which seemed to be growing by the day. Yet, I kept reading, at my then glacial, now non-existent, kanji speed–in the Nihon Keizai Shimbun that these same brokers were losing tens of millions of dollars a year. This state of affairs had been going on for years, with no relief in sight.

I began asking around. What I learned , after a long time of digging, was that all of the Japanese securities trades that customers placed with these brokers were funneled through their Hong Kong offices. In an operational sense, this was crazy. I knew most of the Hong Kong operations of these firms. They knew nothing about Japan, in my opinion. And, of course, this was an extra, possible mistake-inducing, step. Why?

The answer is simple. Japan had, along with the US, the highest corporate tax rates in the world. In Hong Kong, the tax on foreign corporations’ profits was zero. So every foreigner in any line of business established a Hong Kong office and recognized on its tax books as much international profit there as it thought it could get away with.

What’s in this for Hong Kong ? Again, simple. The move created employment, commerce and taxable salary income that the now-SAR would not have had otherwise. The price was only forgoing tax income it would never have had anyway.

The general transfer pricing tax strategy: recognize as much profit as possible in low-tax jurisdictions, the minimum amount in high-tax locations.

turning to the EU today…

Margrethe Vestager, the new EU competition commissioner, is starting a crackdown on what the union considers abusive tax practices. Her first targets are Starbucks and Fiat.

In the Starbucks case, Vestager has two gripes. Both relate to a low-tax corporate subsidiary set up by Starbucks in the Netherlands, using an aggressive tax strategy endorsed as legal by that government thorough an informal tax letter. (The situation is outlined best, I think, in a New York Times article). The subsidiary allegedly:

–bought coffee beans for Starbucks worldwide from Switzerland and marked them up by 20% before selling them to other parts of the company, thus shifting profits away from higher-tax jurisdictions around the globe, and

–levied charges for the use in the EU of the Starbucks name and its secret coffee roasting recipe (which the EU competition commission claims was basically a temperature setting). In the case of the large UK subsidiary of Starbucks these fees for intellectual property apparently amounted to most of its pre-tax income.

Vestager is not saying that Starbucks, Fiat and others did anything wrong. She’s saying the Netherlands, and other countries that offered sweetheart tax deals did. And she wants those countries to collect back taxes.

It will be interesting to see what develops, since presumably every multinational doing business in the EU is employing similar devices.